Alcidi, Busse and Gros: mistaken about inflation

In an interesting article Cinzia Alcidi, Matthias Brusse and Daniel Gros argue that central banks should not target consumer price inflation but should look at GDP inflation instead. They are right to discuss the target variable of central banks. They are wrong about the alternative. As the GDP deflator (which is used to calculate GDP inflation) is influenced by the terms of trade, it is not a reliable indicator of domestic price developments.

I do not accept the idea that central banks should only look at ‘price stability’. They should look at monetary stability, i.e. price plus financial stability. Whch means that they should not only focus on expenditure price inflation but also on debts, house prices and wage levels, to be able to ‘lean against the wind’ in case of unsustainable asset price booms and subsequent bouts of disastrous wage declines and debt deflation (look here for an article on this). Even then, it is good to have some idea of the development of expenditure prices. As (domestic) expenditure does not only consist of consumer spending but also of investments and government consumption (i.e. expenditure on the NHS in the UK, large chunks of education in almost all countries, the judicial system everywhere etc.) it is wise to look at a metric which is more broadly based than consumer price inflation. The GDP deflator is however not fit for this task (at least in the Euro Area) as it is decisively influenced by the terms of trade, as I show here. Which explains the anomalous increase of this variable in 2011 and 2012. The right expenditure price variable to use is domestic demand inflation (the official Eurostat name is: finan consumption expenditure, gross capital formation and exports of goods and services inflation), which is not influenced by the terms of trade but which does track investment and government consumption prices. The graph clearly shows that domestic demand deflation, as it was less influenced by the increases in VAT which all over Europe kept consumer price inflation high in 2011 and 2012, was, after 2006, would have been a much better guide for the ECB than either consumer price inflation or the GDP deflator. Especially the rapid disinflation after 2010 was captured much faster by this indicator than by the other two. Which of course indicates that the post 2010 tightening policies of the ECB, even when you are so wrong to accept that central banks should only target expenditure prices, were totally misguided. As they looked too much at only one part of expenditure prices.

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They should look at monetary stability, i.e. price plus financial stability. Whch means that they should not only focus on expenditure price inflation but also on debts, house prices and wage levels, to be able to ‘lean against the wind’ in case of unsustainable asset price booms and subsequent bouts of disastrous wage declines and debt deflation (look here for an article on this).

central banks should not look at the price level ate of change s a target at all. To do so is to implicitly accept the neutral money axiom– which Keynes rejected. This neutral money presumption simply stated is that changes in the money supply have no effect on employment and output — but have a major effect on the price level. The neutral money presumption is the basis of all classical economic theories– and especially Milton Friedman’s quantity of money theory.

the central bank should concentrate on maintaining all the liquidity the public desires and assure that financial markets maintain liquidity by providing the market maker in each financial market sufficient liquidity to assure that all financial market price changes are ORDERLY! ORDERLINESS is necessary to maintain liquidity in any financial asset market!

Instead the central bank has taken upon itself the function of creating an incomes policy that keeps labor wage demands closely attuned to increases in labor productivity over time. If labor demand for wage increases rises to more than 2% above productivity increases, then the price level of domestic producible goods and services will be inflated by more than 2 %.

In that case, the central bank will introduce a tight money policy to weaken labor power to demand inflationary wage increases– and in doing so, the central bank is using the level of unemployment as the lever in a disguised incomes policy! Why? because orthodox mainstream classical economists do not want the government to interfere directly into controlling labor wage demands that entrepreneurs will give into — as long as there is full employment and firms can sell at any price all that the full employment of labor can produce…

Some decades ago Sidney Weintraub had introduced TIP — a Tax based Incomes Policy– as a direct government control for constraining wage demands without having to create unemployment to limit workers power in the market!

If CBs have set policy as Paul describes, it is a failure: wages in most developed countries are growing more slowly than inflation+productivity. Labour power has been weakened to the point that the labour share of the economic surplus is declining and inequality increasing. It is hard to believe that central bankers can have run these policies with these effects for thirty five years and not done so deliberately.

Paul Davidson

April 24, 2016 at 10:27 pm

my message which Don John missed is that the incomes policy is relevant
only for the market price of DOMESTICALLY produced goods and services.
In Developed nations, the wage share as been shrinking because multinationals hae outsourced production by costly domestic workers to foreign nations where labor costs are a small fraction of the cost of domestic labor. The result is to create unemployment and reduce the wages relative to profits — as outsourcing produces large profits on the imported goods and services to these multinational corporations.

If the Federal Reserves sees signs of labor costs of domestic production rising they will immediate raise the interest rate, thereby reducing domestic demand for products and workers — but this increase in interest rates will also increase the value of the dollar on foreign exchange markets thereby king outsourcing and importing the outsourced production even more profitable relative to wages!

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